Barclays Boosts 2014 Junk-Bond Return Forecast to 6%

By Michael Aneiro

Barclays took a look at a junk-bond market that’s already returned 3.5% so far in 2014 and decided it’s a good time to revise it’s 3.5% full-year return forecast. Coming into the year, Barclays predicted junk bonds would return between 3% and 4%, which would have meant underperforming the market average yield of 5.67% back on Jan. 1. Barclays credit strategists Bradley Rogoff and Eric Gross explain today:

Beyond the predictable returns from coupon and very mild expected losses from defaults, that forecast was mainly predicated on an anticipated path of rates and the extent to which spreads would react. Specifically, we argued that despite a historical beta of -1.0 between spreads and rates, i.e., full absorption of rate moves, we believed that high yield would absorb less of the move this time around. Underpinning that view were several key factors: ultra-low starting yield levels, the end of extraordinarily supportive Fed intervention, and the potential beginning of an era of increasing rates.

Barclays notes that the average junk-bond spread is now 345 basis points, already through the bank’s full-year target of 350 bps, while rates have fallen so far this year and the yield curve has flattened, such that 110 basis points of junk-bond returns so far this year come from Treasury market strength. Barclays again:

Looking to the rest of the year, our rates strategists continue to expect the 5y and 10y to end 2014 higher, at 2.4% and 3.4%, respectively, which are only slightly above consensus. This would equate to a parallel shift of approximately 70bp from current levels – a significant increase…. Meanwhile, the apparent lack of near-term default risk has buoyed the appetite for high yield credit. We see signs of increased risk-taking by issuers… as well as by investors, and expect this trend to continue for some time. Although some of the incremental risk-taking could cause some challenges in the medium to long term, we do not see cause for concern in 2014 and believe high yield will continue to be well supported.

Barclays says its new full-year total return forecast to is 5.5-6.5%, meaning a year-end spread target of 305-325bp given Barclays’ rate forcasts and “consistent with our view that spreads are less likely to fully absorb rate moves in the current environment.”

The persistent growth of retail allocation to loans, stemming largely from widespread concerns that rates are poised for a prolonged period of increases, has vaulted retail funds into second position in terms of ownership share of the loan market (behind CLOs)…. Retail growth has continued since [last fall], albeit at a more moderate pace, taking assets to $153bn, or 22% of the overall loan market.

This streak, like many of its predecessors, was spurred by rates fears….[G]iven the relative stability of rates in recent months, it is understandable that demand has moderated. That said, our rates strategists expect 5y and 10y Treasuries to end the year 70bp higher than current levels…. Unless events cause that to change materially, we think in inflows should resume at some point this year, and any outflows should be relatively mild.